Optimism Bias: It can seriously affect your judgment and trading performance.

Optimism Bias: Is a natural human bias that causes a person to believe that they are less at risk of experiencing a negative event compared to others, or that they are more likely to succeed or be good at something than reality would suggest.

Firstly let me stress, ‘Optimism is good’, most successful traders I work with, as a coach, are typically optimistic, they believe they can beat the market and often do. However they are also self-aware and have a high degree of humbleness (Which tends to run contra to the popular image presented in modern day culture). As an ex-professional trader, I actually think we need a degree of optimism to switch on the screens and start trading every day. We need optimism to return to the fray after the market has given us a severe beating, and we need optimism to balance the natural fears we have which can cause us to panic out of certain trades or which lead to other poor decisions.

However, over-optimism, as emphasized by the optimism bias, can be extremely damaging: It forces people to take trades the should they never should engage in, warping their view of reality, and damaging their objectivity. All of which culminates in a state of ‘unrealistic optimism’! This matters, it matters a lot! As a consequence, people’s decision-making and judgment become heavily impaired, causing them to over-estimate the possibility of favourable outcomes, and under-estimate the likelihood that trades will fail. Ultimately their risk-reward is going to be skewed, perhaps quite heavily. Whether you are an investor or trader, and whether your approach is fundamentalist, technical or quant, whichever method is your poison, you need to have an edge, and that edge is the mathematical outcome of your risk/reward ratio.

This excellent and entertaining TED talk by Tali Sharot talks about the ‘Optimism Bias’ will illuminate you further on the ‘Over-optimism’ bias. 

What can you do to help you over-come the effects of ‘Optimism Bias’ in your trading? Firstly, I would say that you are unlikely to alter your actual ‘optimism bias’, it may vary in certain people and situations, but all people have it. Rather like your shadow, it will always be there, it is a part of you that evolution has welded into your psyche, and that acts in way to impact your perceptions and decisions just below the level of consciousness.

Nonetheless, there are certain ways you can behave or act to try and counter its effects.

1) Raising Awareness is a first step. Hopefully articles such as these are part of raising your awareness of ‘Optimism Bias’, though no doubt within a few days, if not hours of reading this, your memory and conscious awareness of ‘Optimism Bias’ is likely to fade. However a seed will hopefully have been planted that can be nourished through further reading of the human behavioural aspects of decision-making and other memory-stirring practices.

2) Creating a more structured way of trade selection, trade management, and risk-management should help combat optimism-bias. A more structured approach does not have to be too rigid and heavily rule based, by doing so I believe can harm your adaptability and creativity. However by developing certain rules or guidelines and trying to adhere to them, you should create a stronger discipline and allow yourself to create more control over the sub-conscious forces which can derail your trading.

3) Use a Trade Journal or Diary (Either written or electronic). This has many benefits, including:

• ­Supporting a more structured approach as discussed above.
• ­Allowing one to plan their trades more effectively, therefore creating greater objectivity.
• ­Reminding the person of the initial reason and rationale for the trade, and therefore helping to remain on track.
• ­But in this context, I like a trade journal as a ‘Behavioural Awareness’ tool: Let me explain: If you record many of your trading decisions you can then periodically look-back and review your decisions and actions. We rarely learn from our mistakes, because we tend to shut our minds to them. This is part of ‘Optimism Bias’, we don’t want to recall our stupidity or poor-trading as it damages our self-belief, therefore we often banish them from our memory thus allowing us to foster the ‘self-belief’ which is necessary for trading success. Unfortunately, the downside of this is that it also feeds one’s ‘Optimism Bias’. However, by recording reasons for our decisions, and the actions that followed, even just with a few words, (I prefer keeping journals simple: ‘Less is More’), then we can return to them in the future. By reviewing our journals through time, we can raise our awareness of our actions. I use to do this during my trading days and shocked myself when I realised some of the behavioural patterns and mistakes I was repeating. ‘If we are not aware of them, we can’t even start to address them’.

4) There are many other actions we can take to fight the ‘Optimism Bias’, such as seeking alternative opinions, looking at trades from alternative perspectives, active use of Stops/Trailing Stops etc. This is all part of the toolbox one develops during their trading experiences.

On the other hand, you have to ensure that you don’t extinguish your self-belief, it is important to remain optimistic in the face of the many challenges and hurdles that trading throws up. But one should always strive for greater realism and objectivity whilst trying to balance all these various divergent and opposing forces and finding a way which provides a clear edge to one’s trading.

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The 'Behavioural Trading' blog is written and managed by leading Trading Performance and Behavioural Trading Coach Steven Goldstein. Steven is Managing Director at Alpha R Cubed, who work with banks, hedge funds and investment firms to help them improve their people's capabilities within their frontline financial risk businesses. To know more about Alpha R Cubed, visit the website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven directly on Twitter.

Anchoring Bias in Trading. (And you thought you had ‘Free Will’)

Anchoring describes a tendency in our thinking process which leads to us becoming stuck on particular but largely irrelevant reference points which subsequently influences our judgements and decisions. 

Anchoring was highlighted in a famous experiment by Nobel Prize winning behavioural psychologists Daniel Kahneman and Amos Tversky. In the study they asked participants to estimate the percentage of African countries in the United Nations. However before asking the question researchers exposed the respondents to an anchor. They were either asked :

"Is the percentage of African nations that are members of the United Nations more or less than 10%?" 

Or 

"Is the percentage of African nations that are members of the United Nations more or less than 65%?" 

The two numbers 10 and 65 are irrelevant to the question. However those that responded following the 10% anchor guessed on average 25%, and those who had been exposed to the 65% anchor guess on average 45%. The results suggested that the respondents anchored their answer to completely arbitrary numbers presented by the researchers.

How does this affect you as a trader? – One of the effects is to become hooked on your entry level as a reference point, for example let’s say that I enter the market to buy EURUSD FX because I want to go long, I would buy at now at 1.2566, this would now become my reference point, I am likely to be influenced by this number. – This could affect my judgement as I follow the market, obviously it would not be the only factor, however it could sway me towards acting sub-optimally to this trade. –Suppose I place a stop a few points below yesterday’s low at a level of 1.2540, and decide to place a take profit 100 points higher than my entry level. Now assume the EURUSD rallies this over the next couple of hours to 1.2610, then starts to stabilise around 1.2600, I may be tempted to move my stop up to my entry point, thus protecting my profits and avoiding a loss. – This is by all measures a pretty sound strategy, but is it optimal in terms of trading? – My original stop was placed somewhere a bit more relevant, below yesterday’s low point, now it is placed at a level which purely exists because that is where I entered the market where my anchor lies. – Lets also look at some other aspect of the trade, I placed take profit 100 points above my entry at 1.2766, this is another arbitrary number, it relies on the original anchor. It fails to take into account other factors, such as levels of natural support or resistance, pivot levels, trend lines of key moving averages. – It is also possible that sub-consciously this 1.2666 could continue to play an anchoring role throughout the day, influencing my trading judgment sub-consciously. 

Anchoring can affect us and our perceptions of value in all sorts of way in trading, investment and analysis which is not always to our benefit. When key data (E.g. US payroll data) is released on every first Friday of the month the entire market uses the estimates from economists as the anchor for whether the data is good or bad, rather than objectively assessing what this really means for the economy and markets. Too often the original reaction is irrelevant a couple of days later because a more objective assessment of the data has occurred, those traders still holding on to the original anchor can often be trampled over at this stage.

I am sure that we are also vulnerable to being anchored in beliefs which can be heavily influenced by exposure to information, a certain view point, or past experiences, and which can lead to a sub-optimal evaluation of trading prospects. How might this occur, well lets assume you are rather agnostic to rate views in a particular market, however someone hands you a report that suggests rates are likely to rise significantly in the next year, due to factors X, Y and Z. You read it and think you remain agnostic, that you are not bound into any beleif, however now it is quite possible that an anchor has been set in your mind, and future views, beliefs and trades in that market, will be affected by that anchor, rather than a pure objective assessment.  

I will use my own experiences from back in my much younger days to highlight an example: In 1994 I was trading German rate and Bund futures at a large investment bank, through 1994 the bond markets went in meltdown, everything pointed to much higher rates and inflation, it was to prove a very profitable year for me, I was on the right side of much of a very large move. - However the next couple of years proved tortuous, I think that in my mind I had become anchored to the fact that making money came from being short rate futures/long yields. Over the following 2 years the 1994 move was fully reversed, however I was regularly on the wrong side and missed some great trading opportunities.

If anchoring can affect people on an individual level, is it possible that anchoring can also affect the behaviour of the crowd, i.e. many individuals.  It is common for traders to anchor their trading to key high and low points in the market, or previous levels of support or resistance - in my example earlier I place my theoretical stop just below yesterday’s low. These levels can tend to exert an almost gravitational pull on the market, and traders will often place ‘take profits’, ‘stop losses’, exits and entries in relation to these key levels, hence we tend to see volume peak at these key price points (users of ‘Market Profile’ will of course be familiar with this). - It is very common for traders to feel that the market is seeking stops, and many trades become paranoid that the big market-makers and players are teasing with the market, however in terms of anchoring, we can see how much of this is almost a natural phenomenon. 

I come back to the original statement in the title of this post, -‘You thought you had ‘free will’ ’. – ‘Free will’ would imply that you have complete objectivity in your decision making and perception, and complete freedom to make your own choices. – I am afraid to say that sadly that may not be the case. However, familiarity with this behavioural biases, such as anchoring, may start to improve your trading, if you understand the way this affects markets and yourself, perhaps you can start to make small adjustments in your behaviour which can improve your trading performance. 


Image(s): FreeDigitalPhotos.net

Sunk-cost Fallacy : Distorting your objectivity.

 The 'sunk-cost fallacy' is best summed up by the phrase "throwing good money after bad". It is one of those biases which have their root in people’s aversion to losses, and like all these distortions in thinking and judgment, exists just below the level of our consciousness, setting a ‘trading trap’ with the ability to seriously undermine one's performance.

‘Sunk-costs’ are typically unrecoverable costs: In a trading and investment sense they are only unrecoverable when a position is closed out or an investment disposed of. However, this ignores the many other aspects of trading, investment in emotional capital or a particular belief about a market, time invested, cost of running a position (funding/liquidity), and opportunity cost. However, it is often the emotional investment we have put into these which can cause us to avoid closing out/cutting a position.

From a practical perspective how does the ‘Sunk-cost fallacy’ impact traders and investors?

Assume that you own a stock in the belief that it would go significantly higher over a period of a few weeks. Unfortunately, a few weeks later the stock is slightly lower. You have done your homework, you trust your own ability, and all the news since has convinced you more than ever that this is going higher. Thus to back-up your conviction you decide to buy some more. A few more weeks pass and the price is lower again, meanwhile the rest of the market has rallied strongly. At this point on a revaluation basis you are losing money, also you have suffered an opportunity cost against other stocks, you have suffered a time-cost in running the position, and significantly an emotional cost in your ‘emotional capital’ invested in this position and your view. – To close the position now would not only crystallize a loss, but in your mind it would also feel like time, effort and energy totally wasted. – This is where the trap lies, instead of cutting-out, you decide to continue with the position in the hope it will turn around, based purely on how much time, effort and energy you have already put into this for no return or a loss. - What you did however was to base your decision on the effort and resources you have put into the trade, rather than an objective future outlook. Re-stating this another way; your future outlook for this trade is based on what your currently feel about the effort and resources you have put into the trade, and not a clearly thought out perspective of the trade and the market.

As with many behavioural biases, the ‘sunk-cost fallacy’ is really the result of combination of other biases. In all cases ‘loss aversion’ will be a factor, as will the ‘endowment effect’, other factors also affecting individuals could be over-confidence, over-optimism, and 'cognitive dissonance'.

How can one combat the ‘Sunk-cost fallacy’?



This is the tough part; the causes which lead to the beliefs and behaviours which we term behavioural biases are human traits which are part of our make-up, they have helped us thrive as a species, and in many cases helped us at times as individuals. Further to this they typically reside in the sub-conscious and thus are part of our non-conscious decision making and behaviour. Nonetheless, there will be times when they are highly detrimental to our thinking and decision making, particularly in the unnatural environment of the financial markets. Identifying and recognizing when you are succumbing to the pull of biases and irrational and self-defeating behaviours is incredibly difficult,. Traders should however try and develop their ability to be on the lookout for these biases, and an aptitude for reflection and introspection is an extremely useful tool to develop. Keeping a trading journal or diary is one step you could take to help you hone this ability. Traders should also try to question their actions thus allowing a more objective assessment. Discipline and planning are of course great allies; had the investor, in the above example, written out a plan pre-committing to a certain course of action and with various what-if scenarios, he may have had a rough blueprint to guide his actions and thinking. Finally a rule base or at minimum guidelines can keep you out of trouble, this is always a slight conundrum for traders and investors, because too much rigidity stifles creativity and intuition, however good traders develop a sense of when to act in a certain way and when to adhere to their rules/guidelines.